When to sell your stocks to protect capital and profits

Buying and selling stocks. Which is easier?

This is a question I often ask my audience and the common answer was ‘buying’.

That means most find that knowing when to sell stocks is more difficult and I agree. But why so?

This is because at the point of selling you would already know if you have made a profit or a loss. Either way could land you in a dilemma.

If you are making a profit, you might be thinking to sell the stock so as not to lose the profits to the market. But on the other hand, the greed might tell you to hold longer for much bigger profits.

If you are making a loss, the first response is to hold as selling for a loss can be too psychologically painful. But you might also fear the loss can become bigger especially when the market sentiment is bearish.

Hence, a lot of such angel and devil dialogues can happen in the head when it comes to selling.

If you are struggling with such situation…

Construct a sell rule and follow it

One way to handle this is to delegate the decision to a selling rule so that you can do away with the procrastination when it is time to sell. Otherwise, the emotions will always cause you to make suboptimal decision – not selling when you should and selling when you shouldn’t.

There are many ways to construct a sell rule. It can be technical or fundamental analyses but it has to be precise enough so that you know exactly what to do. Sell means sell. There’s no room to interpret it any other way.

For example, you can use a fundamental metric to rank the stocks and you buy the top 20 stocks. In the next ranking, one of your stock dropped out of the top 20 and you just sell it. Don’t need to think so much. Don’t need to look at the charts or the financial statements. The selling rule is very precise.

I will next use a very useful technical indicator to derive a selling decision which I use it in the Quality Momentum Trading (QMT) strategy.

The simple yet effective Moving Average indicator

The technical indicator is moving average.

For those who know, it is probably the very first indicator that you learn when you study technical analysis.

For those who don’t know, it is an average of a stock’s closing prices. A 100-day moving average means the average of the past 100 day’s closing prices. If a new closing price has been generated, it will replace the oldest closing price in the calculation. Hence, the term ‘moving’.

I use a 100-day moving average on the charts and it isn’t a magic number. You can use 50-day or 88-day and the differences are minute. The reasonable range is between 50-day and 200-day. 50-day represents a quarter of a year while 200-day represents a year.

A moving average indicator can be found in most stock charts and the highest utility is to use it to determine when you should sell a stock.

As long as the price is above the moving average = hold.

Price gone below the moving average = sell.

How to protect your capital

Let’s look at some real examples.

Eg 1: Meta Platforms (FB)

First example is Meta Platforms. It was a terrible day for the shareholders on 3 Feb 2022 as the share price tanked 26%!

This could been avoided if you use the Moving Average sell rule.

Below is the stock chart of Meta Platforms and the blue curve is the 100-day moving average indicator.

If you follow the moving average sell rule, you were supposed to sell Meta Platforms at $343 on 22 Sep 2021.

You could have avoided a 41% loss since then as the share price dived to $204.

Eg 2: Netflix (NFLX)

Netflix is another stock that gave shareholders heart attacks, which could also be avoided.

Here’s the stock chart:

Based on the moving average sell rule, you are suppose to sell at $596 on 14 Dec 2021.

You could have avoided a 70% decline in the stock price over a span of 5 months!

Eg 3: Alibaba (SEHK:9988)

The same can be said for Alibaba.

You were supposed to sell HK$248 on 11 Nov 2020.

The stock price was at HK$90 on 6 May 2022. That is a 64% loss over 18 months! Not just the capital loss but the opportunity cost over the period. You could have deployed the capital to another stock.

How to protect your profits?

The magic of moving average doesn’t just protect your capital but also your profits.

In trading, there is this concept of ‘letting your winners run’. This means that you don’t need to decide on a profit target whereby you would sell your stock.

Often times, the stock can go higher than what you think is possible and you might prematurely sell the stock only to find it going higher without you. I am sure this is a common experience.

The moving average will take care of it. As the share price rises, the moving average will rise in tandem. Remember our sell rule is to sell only when the price goes below the moving average. This means that you get to sell higher and higher as the moving average rises, protecting more of our profits.

Eg: CF Industries (CF)

Below is the first example, CF Industries.

I bought the stock on 24 Nov 2021 at $64.81. You can see that the moving average (blue line) has been rising in tandem with the share price.

I have not sold the stock because the price has not gone below the moving average yet. If it does, I would have captured 30% of the profits using this moving average sell rule.

It could also go higher and I get to shift the selling price higher, thereby protecting even more profits.

Eg: ConocoPhilips (COP)

The next example is ConocoPhilips.

I bought ConocoPhillips at $71.28 on 1 Dec 2021. Similarly the moving average has been tracking the rise of the share price and I get to shift my sell price higher.

The share price nearly gone below the moving average on 27 Apr 2022 but it rebounded higher and in fact made another new high in the final bar. You would observe the moving average just keeps going higher and I have protected 27% of the profits thus far.

Every indicator has a drawback

You might be quick to say that the moving average indicator is not a silver bullet to all your selling problems.

It is true that it has its problems and one of which is that you may sell a stock because the price went below the moving average and only to see it rebound without you.

Below is one example with Amazon. After the price went below the moving average, the stock price stayed range bound for many months. This is what the traders call a whipsaw period – the price went above and below the moving average multiple times. And finally it rebounded.

There is no perfect selling rule but this simple moving average could have save your capital or protect your profits in more times than not. Think about saving 70% of your capital or protecting 30% of your profits versus losing 10% of your capital. The moving average sell rule definitely more than pays for itself.

Moving average cannot be used alone

I am just focusing on the moving average indicator in this article for simplification. Please do not use the moving average alone.

The QMT strategy has other parts such as determining the quality of a stock as well as its upward momentum. If you are keen to know how the strategy works, you can sign up for a free webinar here.

The moving average indicator may look simple but don’t belittle it.

It can help you sell without doing too much thinking or analysis. Reduce your emotional burden too.

It can protect your capital, taking a small loss rather than a huge one that is difficult to recover from. Losing 50% requires a 100% gain to just breakeven.

It can also serve as a trailing stop order, allowing you to shift your sell price higher and protect more profits. Instead of selling prematurely with a profit target, you get to maximise your profits by getting out only when a price trend has reversed.